While the Impossible Trinity Theory (also known as the trilemma) has been widely recognized, due to its descriptive nature, very little has been done to test its validity empirically. This paper starts by comparing several recent constructions with regard to this matter and, after making some adjustments to the trilemma index invented by Aizenman et al. (2008), proves the validity of the Impossible Trinity Theory for developing countries. This paper then studies the empirical relationship between a country’s deviation from the average trilemma index and its economic performance. Empirical results find that while the overall deviation does not affect a country’s economic performance, individual deviations as well as regional factors are significant in determining unemployment and the real GDP growth rate.

This dissertation consists of three essays on international capital flows. The first chapter documents the accumulation of foreign exchange reserves and the simultaneous increase in the foreign direct investment (FDI) for emerging market economies. The second chapter discusses the performance of FDI firms and domestic firms in creating jobs using firm-level data from Orbis. The third chapter studies the proper exchange rate and monetary policy when emerging market economies denominate their external debt in foreign currencies. In Chapter 1, I study why emerging market economies hold high levels of foreign exchange reserves. I argue that foreign exchange reserves help emerging markets attract foreign direct investment. This incentive can play an important role when analyzing central banks' reserve accumulation. I study the interaction between foreign exchange reserves and foreign direct investment to explain the level of reserves using a small open economy model. The model puts the domestic entities and international investors in the same picture. The optimal level of the reserve-to-GDP ratio generated by the model is close to the level observed in East Asian economies. Additionally, the model generates positive co-movement between technology growth and the current account. This feature suggests that high technology growth corresponds to net capital outflow, because of the outflow of foreign exchange reserves in attracting the inflow of foreign direct investment, thus providing a rationale to the `allocation puzzle' in cross-economy comparisons. The model also generates positive co-movement between foreign exchange reserves and foreign debt, thus relating to the puzzle of why economies borrow and save simultaneously. In Chapter 2, joint work with Sakai Ando, we study whether FDI firms hire more employees than domestic firms for each dollar of assets. Using the Orbis database and its ownership structure information, we show that, in most economies, domestic firms tend to hire more employees per asset than FDI firms. The result remains robust across individual industries in the case study of the United Kingdom. The analysis shows that an ownership change itself (from domestic to foreign or vice versa) does not have an immediate impact on the employment per asset. This result suggests that different patterns of job creation seem to come from technological differences rather than from different ownership structures. In Chapter 3, I investigate how the devaluation of domestic currency imposes a contractionary effect on small open economies who have a significant amount of debt denominated in foreign currencies. Economists and policymakers express concern about the "Original Sin" situation in which most of the economies in the world cannot use their domestic currencies to borrow abroad. A devaluation will increase the foreign currency-denominated debt measured in the domestic currency, which will lead to contractions in the domestic economy. However, previous literature on currency denomination and exchange rate policy predicted limited or no contractionary effect of devaluation. In this paper, I present a new model to capture this contractionary devaluation effect with non-financial firms having foreign currency-denominated liabilities and domestic currency-denominated assets. When firms borrow from abroad and keep part of the asset in domestic cash or cash equivalents, the contractionary devaluation effect is exacerbated. The model can be used to discuss the performance of the economy in interest under exchange rate shocks and interest rate shocks. Future directions for empirically assessing the model and current literature are suggested. This assessment will thus provide policy guidance for economies with different levels of debt, especially foreign currency-denominated debt.

This dissertation studies topics in international finance and central bank policy. In the first chapter, "Common idiosyncratic volatility and carry trade returns", I provide new evidence that incomplete consumption risk sharing across countries is an important determinant of carry trade returns. I show that there is a strong co-movement in idiosyncratic volatilities over time, and that shocks to the common idiosyncratic volatility (CIV) factor, defined as the equally weighted average of the idiosyncratic volatilities in the cross-section, are priced. I find that high-interest rate currencies deliver low returns when the CIV increases, which are bad times for investors. Low-interest rate currencies provide a hedge by yielding positive returns. CIV shocks remain an empirically powerful risk factor in explaining the cross-section of carry trade returns after controlling for global foreign exchange (FX) volatility risk. Furthermore, CIV risk is correlated with cross-country income risk faced by households. My findings are consistent with a heterogeneous-agent model with persistent, uninsurable idiosyncratic shocks in consumption growth. The calibrated model quantitatively accounts for the cross-sectional differences in average returns across CIV-beta sorted portfolios for plausible market prices of CIV risk. In the second chapter, "Fed-implied market conditions", we propose a novel text processing technique to extract views of market conditions that are implicit in the Fed's policy statements and minutes. The method is easy to apply and addresses several problems inherent in the use of changes in interest rates as a proxy for central bank policy. First, we project market variables into the text of FOMC statements and minutes (separately) using support vector regressions (SVRs) to predict the levels of 10-year yields, 3-month yields, 2s10s, DXY index, VIX, high-yield (HY) and investment-grade (IG) spreads. We then define measures of monetary policy (``FDIF'' variables) as the Fed-implied deviation away from the market variable: the out-of-sample value of the market variable implied by the SVR minus the corresponding value of the market variable the day before the statement (minutes) release. We show that different markets respond differently to monetary policy news in the short-run, in a way that has independent and complementary implications for market movements in the long-run. Fed news also has important long-run implications for macroeconomic outcomes. Our Fed measures outperform Bernanke-Kuttner and changes in 2-year yields for forecasting macro and financial outcomes in the future. Finally, we show that there are Fed-risky and Fed-hedging industries, and these earn risk premia on Fed statement days. Finally, in the third chapter, "Does the counterparty of central banks in derivatives-based foreign exchange interventions matter?", we study how the central bank counterparty in foreign exchange interventions affect the supply of hedge against FX risks to the private sector. We use Brazilian data where derivatives-based interventions have been used in tandem for almost two decades. The analysis finds evidence of a link between central bank counterparties in FX swap operations and the supply of hedge through FX futures contracts. The main central bank counterparty in foreign exchange interventions uses the liquidity provided by the central bank to increase the supply of hedge to the private sector. Other counterparties use the US dollars provided by the central bank to reduce their own foreign exchange exposure.

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This thesis studies the problems of semistatic trading strategies in a discrete-time financial market, where stocks are traded dynamically and European options at maturity are traded statically. First, we show that pointwise limits of semistatic trading strategies are again semistatic strategies. The analysis is carried out in full generality for a two-period model, and under a probabilistic condition for multi-period, multi-stock models. Our result contrasts with a counterexample of Acciaio, Larsson and Schachermayer, and shows that their observation is due to a failure of integrability rather than instability of the semistatic form. Mathematically, our results relate to the decomposability of functions as studied in the context of Schrödinger bridges. Second, we study the so-called martingale Schrödinger bridge 𝑄⁎ in a two-period financial market; that is, the minimal-entropy martingale measure among all models calibrated to option prices. This minimization is shown to be in duality with an exponential utility maximization over semistatic portfolios. Under a technical condition on the physical measure 𝑃, we show that an optimal portfolio exists and provides an explicit solution for 𝑄⁎. Specifically, we exhibit a dense subset of calibrated martingale measures with particular properties to show that the portfolio in question has a well-defined and integrable option position.

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